II The Rationale for Central Banks

Charles Collyns
Published Date:
March 1983
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Central banks in the developed world are given a wide range of public responsibilities and endowed with a correspondingly broad array of executive powers. The activities of these institutions can be grouped into five general functions:

  • Currency issue and management of foreign reserves

Provision of a national currency involves the physical production and distribution of notes and coins, operations in foreign exchange markets to guide the currency's rates of exchange with other currencies, and the management of the reserves of foreign assets held to sustain the national currency's external value.

  • The role of banker to the government

This function involves providing bank deposit and borrowing facilities to the government and acting as fiscal agent and underwriter for the government. It also includes giving technical advice to the government on monetary policy and financial affairs.

  • The role of banker to domestic commercial banks

This function normally includes the acceptance of deposits to act as prudential reserves for these banks, the willingness to discount commercial and government paper for these banks, and the commitment to act as lender of last resort to these banks. It may also involve the provision of central clearance facilities for interbank transactions.

  • The regulation of domestic financial institutions

This activity involves ensuring that commercial banks and other financial institutions conduct their businesses on a sound, prudential basis and according to the various laws and regulations in force. It includes the monitoring of reserve ratio requirements and the supervision of banking conduct.

  • The operation of monetary and credit policy

This function involves the manipulation of monetary and credit policy instruments in seeking to achieve the government's chosen macroeconomic strategy and/or constitutionally mandated objectives. This task may require actions to influence monetary aggregates, exchange rates, interest rates, and the distribution of credit.

A satisfactory rationale for central banks must logically proceed in two stages. First, it is necessary to explain why it may be advantageous for certain activities in a financial system to be performed by institutions with explicit public responsibility rather than left to the marketplace. Second, one needs to argue that these functions should be entrusted to a single centralized authority which is discrete from, rather than an integral part of, the government. This section provides such a rationale for a central bank within the general context of a typical developed country; it presupposes a country with a complex economy, a sophisticated financial system, and a welleducated population.

Why Central Banking Institutions?

All of the functions described above are intended to contribute to the efficiency and stability of a financial system that is conducive to overall economic prosperity. Reasons may be given to believe that in each case the function would be more effectively performed by a publicly responsible body than by private institutions seeking their own ends.

Regarding currency issue, money ideally serves as a convenient means of exchange, as a secure store of liquidity, and as a stable unit of account. The provision of a national fiat currency allows the seigniorage 1 obtained from currency issue to accrue to the home country. In theory, each domestic commercial bank could be permitted to issue its own currency without the home country forfeiting the advantage of seigniorage. Indeed, it may be argued that it would be appropriate to give commercial banks the right of fiduciary issue; this would permit market forces to act to ensure the efficient provision of currency.2 Under such an arrangement a person's desire to hold a particular bank's currency would depend on the convenience of use of that currency and on the stability of its exchange value. Banks would earn seigniorage to the extent that their own currency possessed these properties.

One flaw in this argument lies in the economies of scale inherent in the production of and, crucially, the use of fiat money. There would be a strong tendency for one private currency to dominate the rest because of the reduced transactions costs associated with the use of a common currency, which would be immediately recognizable, readily disposable, and the unit of account. However, once such a monopolistic position were established, the discipline of the market would no longer constrain the issuer of currency to be efficient.

The position of banker to the government is a powerful one. It is clearly important for the government to have access to specialized financial expertise untainted by the influence of any outside interest. In addition, the government's typical scale and central position in the economy would require that its banker take due account of its impact on the economy, particularly in decisions on how far to finance the government's credit requirements.

The functions of banker to domestic commercial banks and of regulator of these banks' behavior are closely linked. These activities are directed toward two basic objectives. The first is to safeguard the stability of individual banks. Without central regulation, bank customers could face considerable problems in ascertaining the relative security offered by different banks' services. The imposition of reserve ratio requirements and the supervision of banking conduct are intended to ensure that the supervised financial bodies all maintain a certain standard of security, on which their customers may then rely.3 At the same time, individual bank stability contributes to the stability of the financial system as a whole. Problems may arise when individual banks within the system are heavily indebted to each other. Then the fate of a particular bank may have repercussions throughout the financial system that individual lenders fail to take into account. Central provision of lender-of-last-resort and discounting facilities can recognize these repercussions and, hence, reduce the chances of bank failure spreading through the system.

Aspects of each of these broad functions—in particular, the issuing of currency, the holding of government debt, the setting of reserve requirements, and the stance of the lender of last resort—have strong implications for the exchange rate, domestic interest rate conditions and the availability of credit, and hence for economic activity. The use of monetary policy to influence macroeconomic conditions is, of course, a highly controversial and widely debated topic. To simplify, most economists would probably accept that if domestic labor and product markets were not fully competitive and responded slowly to shifts of the economic environment, there would be scope for policy intervention to speed adjustment to external shocks to the economic system even if financial markets were both competitive and stable. The key issue is then whether the costs and uncertainties involved in such action in practice do not outweigh the potential benefits. While many economists believe that countercyclical intervention can be effective in certain circumstances, others are more skeptical, and would argue that monetary policy should be primarily concerned with the preservation (or restoration) of a stable and predictable monetary environment.

Why Central Banks?

Central banks are organizations that fulfill two criteria: (1) they undertake most of the functions ascribed above to central banking institutions (at least acting as issuer of currency, banker to the government, and banker to commercial banks); and (2) they exercise considerable discretion in the choice of the means if not the objectives of their operations.

The benefits of establishing many of the central banking functions within a single entity are easily explained. First, there are economies of scale to be gained from entrusting these functions to one organization that may develop a considerable body of financial knowledge and expertise. Second, the close links between the functions make it advantageous to establish a single body, with wide-ranging powers of investigation and execution, to be held responsible for the overall functioning of the financial system. In practice, the range of functions undertaken by central banks does vary even between developed countries, but the functions that are sometimes incorporated in separate institutions are usually specialized ones—such as the physical production of currency, the provision of deposit insurance, and the licensing of financial institutions—that are not central to the operational task of financial management.

The reasons for the typical operational independence of the central banking institution are again mainly practical ones. Clearly, for the central banking institution to make rapid and flexible responses to a fluid financial environment, it must have at least day-to-day operational independence. It is true that such limited independence would not preclude the central banking institution being, for example, merely another section of the finance ministry; but independence from the finance ministry may be desired as a check and a balance to that ministry in the analysis and formulation of economic policy. Even so, such independence would not be incompatible with the central banking institution being embodied, for example, in a separate ministry of monetary affairs whose minister sat in the cabinet. However, a clear separation from the government altogether would make it easier for the central banking institution to establish close links with the financial community.

A more controversial issue is the question of whether the central banking institution should be subject, in the last resort, to the decisions of the central executive office of government. The orthodox view would be that monetary policy, as an important lever of power, should ultimately be subject to democratic sanction; while the central banking institution may be given a separate voice in policy debate, the final voice should belong to the representative government. The opposing view would emphasize that monetary policy—like the administration of justice—must be able to resist undue political pressures. It can be argued, for example, that central banking institutions should be constitutionally mandated to seek the long-run objective of monetary stability on the grounds that permitting political guidance of policy objectives would inevitably lead to policy actions designed to achieve short-run advantages to the ultimate detriment of the economy. Such arguments hinge on the view that the electorate itself would be shortsighted in exercising its choice of government and on the economic theory that only unanticipated monetary policy would provide an effective instrument to manipulate domestic output and employment.4 But even if it were to be determined that full independence would be desirable in principle, it would still be necessary to establish an institution that would indeed be capable of standing against both political and popular pressures.

In practice, the central banking institution's degree of independence from government does vary considerably even within the developed world.5 The constitutionally guaranteed independence from the executive of the Federal Reserve Board and the Deutsche Bundesbank may be contrasted with the Bank of England's customary independence in the operation of monetary policy but not in the selection of goals and with the close supervision experienced by the Bank of France. It should be noted that both the United States and the Federal Republic of Germany have federal political structures in which constituent states provide a counterweight to the central government. Also, independence de facto would depend, at least in part, on the personalities of the senior politicians, civil servants, and central bankers involved and on the support each group would receive from the banking establishment and elsewhere.

Central banks could be classified by assessing (1) their involvement in the execution of each of the tasks specified above, and (2) the degree of independence exercised in the execution of each of these tasks. For the present purposes, it is sufficient to concentrate on an ideal or archetypal “full-fledged central bank” that is characterized as being fully involved in each of the five typical functions of the central banking institution and also as having considerable, if not complete, discretionary powers to undertake these functions.

Seigniorage is used in the broad sense to refer to the pecuniary benefit derived from the issue of notes and coins as noninterest-bearing liabilities rather than in the narrow sense of the excess of the monetary over the bullion value of coinage.

See, for example, Hayek (1976).

With a system of deposit insurance in place to protect depositors, regulation would still be required to ensure that banks attained the minimum standard of security necessary to ensure the viability of the insurance scheme; see Giddy (1982).

For a neat if simplistic illustration of such an argument, see Kydland and Prescott (1977).

For a survey of the degrees of independence exercised by central banks in 16 developed countries, see Fair (1979).

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